A Fool and His Money Are Soon Parted (Investing vs. Gambling)

The savvy investor – or, more aptly, the investor who survives and earns a fair return over the long term – knows the difference between investing and gambling.

Webster’s Dictionary says:

Invest means to commit money to earn a financial return.

Gamble means to play a game for money or property.

Notice the difference? Investing is a serious matter. It’s business. It involves commitment, and the purpose is to earn financial return. When you succeed and earn a profit, you are not surprised. In fact, the big surprise comes when you suffer a loss.

Gambling, on the other hand, is a game. It’s not serious. It’s for pleasure and the outcome is uncertain. In fact, the outcome is mostly a matter of chance. When you win, you say, “Oh, wow, that was great!” When you lose you say, “Well, such is expected.”

Here are some additional distinctions.

Better Chance of Profit Than Loss.

Investments provide better odds for profit than loss, and this is determined by a reasoned, thorough and objective investigation of the facts. Of course, such an investigation on most games of chance leads one to conclude that the odds of loss are greater than the odds of profit. If you are considering a proposition and you do not have sound, fact-based reasons to conclude that a profit is likely, it’s not an investment opportunity. It’s gambling.

Quantity and Quality of Information.

The investor cannot, of course, determine whether an opportunity is worthy of his/her time and dollars unless he/she is provided with all of the information he/she deems necessary to adequately assess the opportunity. This involves issues of quantity (i.e., information of adequate supply on every factor that could impact the prospective future returns) and quality (i.e., the degree to which the information provided or obtained can be relied on to be true, accurate and credible). If information about an investment is not available in adequate quantity or quality, the investor cannot conclude that the investment is suitable.

Performance History.

Maybe the most vital piece of information is past performance history. For investments in businesses – whether publicly or privately held – this entails an analysis of the historical financial statements (i.e., income statements, balance sheets and statements of cash flows). The time horizon should be many years and, importantly, span a period of time that includes a recession (both in the industry in which the business operates and a broad economic downturn such as in 1973-1975, 1982, 2001 and 2008-2009). Only by analyzing performance during more challenging times can one really assess how the business might perform during such times in the future.

Speculation.

Investments do not involve speculation, which is defined as the “assumption of unusual business risk in hopes of obtaining commensurate gain.” Investments do not contain elements of hope. In contrast, investment decisions are based on a reasoned, thorough and objective assessment of the facts. If hope is at play in your decision to invest, what you’re doing is gambling.

Capital Preservation.

The ability to invest and earn income may be the greatest gift known to man this side of eternal salvation. To be able to earn income without the need to labor is what separates – dare I say elevates – the investment class from the working class. So, to the investor, nothing is more important than preservation of capital. Lose your capital (aka principal) and you lose your ability to invest. If you are considering an investment that could result in a total loss of your capital (i.e., the amount you invest), it’s not an investment.

Margin of Safety.

Investments that could result in total loss are not investments, they are gambles, and the only way to avoid the possibility of total loss is the concept of “margin of safety.” How is margin of safety assessed? By a reasoned and objective assessment of the facts. One must ask, “What is the worst-case scenario and, in that scenario, what is my return on investment?” For investments in businesses, whether the investment is in the form of debt or equity, one looks to:

• Historical and projected cash flow in good times and bad
• The certainty to which cash flow – in the worst-case scenario – will be able to meet all obligations, including, of course, operating costs and fixed obligations such as rent and debt service
• Tangible asset values relative to debt (aka debt-to-equity or leverage)

Return on Investment.

Investment is an activity engaged in to gain a return on investment, that is, a return of the capital deployed (i.e., the dollars invested, commonly referred to as the “principal”) PLUS a risk-adjusted return on investment. Of course, one will at times lose some principal on an investment, but this should be a worst-case scenario and, if five or ten investments are made, the overall return should be very positive (see “diversification” below).

Return of Investment.

An investment – even a risky investment – should at the very least provide a return OF your investment. That is, a return of your principal. Again, to the investor, capital preservation is paramount. One might be willing to accept some uncertainty as to the return ON investment, but a return OF investment (i.e., a return to you of the money you invested) should be virtually assured except in cases such as venture investment where diversification is used in a manner that allows losses on investments to be recouped by sizeable gains on others.

Diversification.

An absolutely fundamental and essential principle of sound investment strategy is that of diversification. Diversification, at its most basic, is a means for protecting against random risk. That is, risk of loss due to events that cannot be predicted or foreseen. Events such as these DO occur, and the only protection against them is the old adage “don’t put all your eggs in one basket.”

Time Horizon.

Games of chance tend to play out in very short time horizons. When you place your bet on a craps table or on a ball game, you learn your fate almost immediately. Investing, in contrast, involves longer time horizons, typically years. Returns may not be realized until many years after the investment is made, but the rate of return is calculated, or assessed, in average annual rates of return. The Internal Rate of Return (IRR) calculation is most common.

Time Value of Money.

Because investment returns are often distributed over many years, and because a dollar today is worth more than a dollar tomorrow, the investor will require much higher rates of return on investments that have a longer time horizon. Inherent in the concept of time value of money is:

• Need for inflation-adjusted return on investment
• Uncertainty rises considerably as returns are projected further into the future

So investors want to secure a return OF their investment (i.e., their principal, the investor’s highest priority) within as short a time as possible. Similarly, investors place a higher value on investments they expect will provide a return on investment over a shorter time horizon.

Optimism vs. Arithmetic.

The decision whether to enter into a particular investment should be based on arithmetic, not optimism, hope or blind faith. If your decision about whether to accept a proposition is based on whether others are doing it, run away. Any decision to invest should be founded on a fact-based investigation and whether, all things considered, you can reasonably expect both a return OF your investment and a return ON your investment that fully compensates you for the risk.

Risk and Required Rate of Return.

Any investment analysis includes an assessment of expected return in relation to degree of risk. Riskiness can be defined as variability in expected returns. Again, investments, by their nature, have variability as to return but should not also contain uncertainly as to whether a return will be earned at all. Also, as risk or unpredictability levels rise, the investor should demand higher returns to compensate. In short, very safe investments (i.e., investments in government securities or in debt instruments of financially healthy “blue chip” public corporations) should reliably return annual rates that exceed the rate of inflation by at least a few percentage points. On the other end of the risk spectrum, equity investments in new business ventures should provide annual returns in excess of (and, often, well in excess of) 25 percentage points above the projected rates of inflation.

Investment Performance in Difficult Economic Times.

Many poor investment decisions are made during times of broad economic prosperity. When the economy or industry has expanded for four or five years in a row, many businesses and/or investments show promising track records of performance. The wise investor takes care not to assume that good times will continue indefinitely. You must assess how the investment will perform during difficult times, most likely right after you place your bet.

Guilty Until Proven Innocent.

Investing is not about fairness. It’s not about compassion. It’s not about pleasing people. It’s about earning a cold-hearted return on investment. It’s about the dead-serious business of ending up with more cash than you started with. If a reasoned and objective assessment of the facts cannot be used and lead to the logical conclusion that a fair risk-adjusted return will be earned, then the proposition cannot be deemed an investment, at least not a suitable one.

Thomas Tusser wrote that “a fool and his money are soon parted,” and every investor should keep this in mind at all times. Every investor’s perennial ambition should be to prove he is no fool. Benjamin Graham and Warren Buffett, widely accepted as the greatest investors of the past 100 years, both assert that it is not hard to succeed at investing and earn healthy returns over the long run; one need only adhere to sound investment principles. The litmus test is the issue of hope vs. rational expectation based on sound assessment of facts. If you find yourself including elements of “hope” or “excitement” in your decision whether to put your money into a proposition, you’re not investing, you’re gambling.

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The following provided meaningful guidance for this article:

Cottle, Sidney; Murry, Rogers F; Block, Frank E. Graham and Dodd’s Security Analysis, Fifth Edition. McGraw-Hill. 1988

Graham, Benjaim. The Intelligent Investor, Fourth Revised Edition. Harper Business. 1973.

Hangstrom, Robert, G. Jr. The Warren Buffett Way. John Wiley & Sons, Inc. 1995.